Wednesday, February 24, 2016

The Sanders Fiscal Stimulus and Verdoorn’s Law

“If Friedman and others are right, it would up end most of mainstream macro, and would force a dramatic reconsideration of economic policy. But Friedman’s paper seems far-fetched because the normal action of stimulus -- putting unemployed people back to work -- wouldn't be nearly enough to create the kind of growth Friedman projects. In addition, we would need a huge boost to the growth rate of productivity. Usually we think of productivity gains as coming mainly from technological advancements, something that is very hard for government policy to affect. The notion that fiscal stimulus, in addition to raising employment, also boosts productivity growth was first suggested in 1949 by a Dutch economist, Petrus Johannes Verdoorn. According to what's known as Verdoorn’s law, all you have to do is boost gross domestic product growth -- for example, by fiscal stimulus -- and productivity will soar as well.”

The importance of increasing returns for economic growth was revitalized only in the early twentieth century by Allyn A. Young (1928), who emphasized not only the reduction in the average cost of production brought by output growth in manufacturing but also the product diversification that characterizes an increase in the division of labor. Verdoorn’s law, an attempt to quantify this relationship, is named after the Dutch economist P. J. Verdoorn, who published a paper in 1949 in which he measured the impact of economic growth on labor-productivity growth in manufacturing for a group of countries in the late nineteenth century and early twentieth century. In general terms, Verdoorn’s law implies the existence of a stable and positive causal relationship from the growth rate of output to the growth rate of productivity in manufacturing in the long run. … The theoretical foundation of Verdoorn’s law is the existence of economies of scale in manufacturing, that is, the fact that the average cost of production falls with an increase in the amount of goods produced. The sources of economies of scale within a firm or industry are usually divided into two categories: static or dynamic. Static economies of scale come from the fact that most processes of production incur a fixed cost, that is, a cost that has to be paid no matter whether anything is produced. As a result, the higher the level of production, the lower the average fixed cost per unit produced and consequently the higher the economy of scale. It should be noted that static economies of scale are reversible because, if production is reduced, the average fixed cost rises. Dynamic economies of scale come from the productivity gains associated with innovations brought about by the increase in production. The intuition here is that the dynamic economies arise from learning by doing and as such are irreversible. Even if the level of production falls, the new knowledge acquired from experience does not vanish.

There is more on the empirical inquiries that occurred after Kaldor drew attention to this idea in 1966. I have been saying Team Bernie needs to hire economists to model out the economic effects of his policy proposals. This Verdoorn effect might be something worth exploring.

10 comments:

This makes sense but it is also one of those empirical relationships -- like the EKC I mentioned a few days ago, or NAIRU -- that can easily be gamed if people aren't careful that they aren't mistake a relationship for a "law'.

Or Okun's "law", Say's "law", the Cobb-Douglas production function, the Kuznets curve, the Phillips curve, the Kondratieff wave, the labor/leisure trade-off, the Jevons paradox. The list goes on... and on... and on...

Thanks. Spelling corrected and my Dutch was always awful. And good point about gaming relationships. If I ever write an economic text, the word "law" will appear nowhere. I tend to hate lawyers anyway.

There is actually one economic "law" that I know of no violations of. That is the law of diminishing marginal returns, aka "the law of diminishing returns." This does not say they always decline, only after some critical level of the varying input. I think every other so-called economic "law" that I have ever seen has at least one exception.

Please don't put Okun and Cobb-Douglas in the same category! One is a well-established empirical relationship between concrete observables -- exactly what a positive economics Luke be looking for. The other is a purely theoretical construction in the fantasy world of some homogeneous substances called "capital" and "labor".

JW - I don't think Tom was saying all were in the same category. As much respect as I have for Art Okun, I think even he would admit economic research has moved well past the memos he was writing for the President a half century ago.

It certainly makes sense to me for any period in which demand is growing. Demand when in a rapid growth phase -- wow, when did we last see that? -- will stay ahead of the ability of employers to hire new workers, so those employed workers will constantly be pushed to keep up with producing more output. It is not only the employer's ability to hire rapidly, but also desire, because employers are still going to try to get away with hiring as few as possible and increasing production per worker.

I have no idea what your list means. Axioms are things you assume, not necessarily things that are really universally true. Thus, what is the "Axiom of Supply"? That the curves slope upwards? They do not always do so. How about the "Axiom of Demand" (or "Law of Demand"). Is that those curves slope downwards? They do not always do so. "Okun's Law" is at best an empirical regularity that sort of holds, which is sort of what Verdoorn's Law is.

It may only be an empirical regularity, but I know of no exception to the Law of Diminishing Returns. Back in 1919, Julius Davidson argued that it holds because of the Law of Entropy. I would not go that far, but it remains the only economic "Law" "Axiom" or "Empirical Regularity" for which I know of no exception.

Oh, and "Say's Axiom" (or "Law," as most refer to it) is also not universally true as was understood by Say himself, of all people.